“Dream Paychecks”: Thoughts on Hedge Fund Returns & Fees

We’re going to start commenting on investing/financial items we read or hear about in the media, in the hope that it’s interesting and informative for you. Please let us know if you have any comments or questions.

Our first post involves the 5/16/17 NYT article titled “Dream Paychecks.” It discusses the enormous 2016 earnings for hedge fund managers (ranging from $1.6 billion [not a typo] to about $100 million), many of whom significantly underperformed the broad stock and bond market indexes for the year. “The 25 best-paid hedge fund managers earned a collective $11 billion in 2016, according to an annual ranking published … by Institutional Investor’s Alpha magazine…. Nearly half of the top-25 earners made single-digit returns for their investors, a lackluster sum in a year when the S&P 500 stock index was up 12%, accounting for reinvested dividends.” To be fair, not all hedge funds invest exclusively in stocks, and so the S&P 500 might not be the best benchmark for all of the funds managed by the highest-paid managers. And as the article notes, “the original allure of a hedge fund was the promise of smoother returns during market upheavals along with risk-adjusted returns that would stand out.” But many of these funds and their managers have risen to prominence, and outsized pay, by taking enormous risks in search of market-beating returns, which have not occurred recently for several well-known managers. The article mentions John Paulson, “who is best known for reaping a windfall by betting on the collapse of the housing market in 2008, [and] has made $15.45 billion over the 16 years Institutional Investor has been compiling the list. But he was bumped off the list after double-digit losses in 2016…” Also mentioned is William Ackman of Pershing Square Capital Management, who “has had percentage losses in the double digits for two years in a row.”

The main points from PPA’s perspective are that active managers, whether of hedge funds, private equity funds, or simply actively-managed (as opposed to passively-managed or indexed) mutual funds, take big risks that might generate outsized returns over certain periods, but always have the possibility of significant declines in other periods. This lack of “persistence” in the returns of active managers is one of the main reasons PPA prefers index funds to implement client portfolios. And the cost of this significant risk, which is in turn “the key to these large paydays [at least for most hedge funds,] is the fee system known as 2-and-20. Hedge funds typically charge investors 2% of their investment annually, regardless of performance… In the event they make a profit, the funds take 20% of that as well.”

Please let us know if you’d like more information about how PPA, a registered investment advisor with a fiduciary duty to put our clients’ interests first, provides asset allocation advice focused on clients’ goals and implemented with low-cost indexed investments.